How much should you set aside for financial emergencies?
As a nation, our financial resilience has been put to the test over the last few months.
Fortunately, for many of us, the financial implications of the coronavirus pandemic have had less impact than might have otherwise been the case, thanks to the government’s support schemes.
But this is an excellent time to reassess your financial resilience and to consider if you are sufficiently well prepared for future emergencies, whatever they might be.
The received wisdom from the financial advice community is that you should have between three and six months’ worth of income put to one side, in cash or Premium Bonds, to enable you to cope with emergencies.
This received wisdom doesn’t stand up to much scrutiny. It’s always struck me that there should be a more logical way of working out how much you need for emergencies.
In my experience, there are three determinants, which you should use to calculate the size of your emergency fund:
1 – Your stage of life
2 – You access and attitude to borrowing
3 – The amount which makes you feel comfortable.
The most recent research into financial emergencies is some seven years old now, but still useful.
Some things have changed since then (we’ve become more reliant on home computers and smartphones). But it’s clear from that research that your stage in life will affect the size of the emergency fund you need – and, in particular, people with children experience more unexpected costs in a year than those without children.
The most common unexpected costs were car repairs and replacement, opticians fees and glasses, dental expenses, technology and phones, pets, washing machine and home repairs, and lending to family and friends.
Lending to family and friends was the most expensive unexpected cost, followed by car repairs and replacements.
Some of these “unexpected costs” come up so frequently that they really shouldn’t be unexpected – for example, we should all be budgeting for repairs to our cars, and you’ll inevitably need to replace your glasses now and then.
The best way to deal with these costs is through saving (these expected costs should be part of your annual budget).
If you are responsible for several cars (including those of young adults!), own your home (and maybe a holiday home), and have children and pets, it’s more likely that you’ll have to deal with a financial emergency, so your emergency fund should, therefore, be more significant.
If you are employed, as opposed to being retired, it’s sensible to have some money set aside, which you can access, in case you lose your job – so, for this reason, during your working life, it’s advisable to have money set aside for this eventuality.
Once you’ve retired, you don’t need to worry about losing your job, so there’s one less emergency to worry about, and your emergency fund can be smaller.
The availability of borrowing varies significantly from one person to another, according to life stage, but most of us can borrow money if we need to.
Many take the view that there is no point in leaving cash available for emergencies, particularly as the returns paid by immediate access savings accounts are so poor.
If you adopt this approach when an emergency comes along, it can usually be covered on a credit card, at least in the short term, and the credit card balance can then be repaid.
There is a logic to this for those who are working, particularly when credit cards offer extended zero interest periods. If you are in a position where you can clear debt quickly, and borrowing doesn’t result in sleepless nights, this is a reasonable approach.
However, many of us feel uncomfortable about borrowing, and the average number of unexpected costs per year is about 1.6, so, if you take this approach, it is perhaps inevitable that the credit card will need to be used during the year.
So, if you don’t like going into the red, this won’t be the right approach for you.
Over the years, I’ve had many a conversation with clients about how large their fund for emergencies should be. And, much of the time, the logic about the size of the fund needed is outweighed by the “round number” in the client’s mind.
I’ve always taken the view that, if the round number is larger than the logical calculation then that is fine, as long as the client realizes that long term returns on emergency funds are generally lower than they are for invested funds.
The amount you set aside for emergencies is a matter of personal preference.
It’s better to work out the amount you need in conjunction with a financial planner, who can act as a critical friend and help you decide how much you might need.
In the next blog post, I’ll look at the best ways to build up your emergency funds, and where to keep the money you need for a rainy day.